Edited version of private advice

Authorisation Number: 1012679124162

Ruling

Subject: Interest expense

Question 1

As beneficiaries of the trust, are you entitled to claim interest accrued on a personal loan established for the purpose of investing in the trust?

Answer

No.

Question 2

Is the trust entitled to claim interest accrued on a personal loan which was invested in the trust by the beneficiaries?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

Year ending 30 June 2018

Year ending 30 June 2019

The scheme commences on:

1 July 2011

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

A discretionary family trust was formed for the purpose of buying land on which to construct townhouses and sell them upon completion for profit.

A corporate trustee company was formed to act as trustee to the trust.

You are both beneficiaries of the trust.

Two properties were purchased by the trust to carry out the development venture.

Construction of townhouses commenced and was financed by a set of two bank loans.

The first loan was made by the trust (via the corporate trustee) and was secured against the proposed construction of the townhouses.

The second loan, which was directly invested in the trust, was jointly made by the beneficiaries. This was secured against a home loan.

The second loan was borrowed personally and was invested in the trust's business venture to construct townhouses. It was not on-lent, and no payments were received from the trust in light of the moneys invested.

The purpose of the investment was to derive income by the way of profit upon the sale of the townhouses. The beneficiaries are yet to receive any distributions as the trust is currently running at a loss.

The completed townhouses are currently unsold, but remain on the market for sale. Until they are sold, the townhouses are being rented out to cover holding costs.

The rental income covers a reasonable portion of the total interest payments incurred as a result of the loans.

Relevant legislative provisions

Income Tax Assessment Act 1997 (ITAA 1997) section 8-1

Reasons for decision

Question 1

Summary

As beneficiaries, you are not able to claim interest expense under section 8-1 of the ITAA 1997 as you are not presently entitled to any distributions from the trust.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature. No deduction is allowed if the outgoings relate to the earning of exempt income or a provision of the taxation legislation excludes it.

The Commissioner's view on the deductibility of interest expenses incurred by a beneficiary of a discretionary trust is set out in Taxation Ruling IT 2385.

It is the Commissioner's view that expenses incurred by beneficiaries of trusts, in relation to trust income, are not deductible unless it can be established that the beneficiary was presently entitled to the trust income when the expenditure was incurred.

As a beneficiary of a discretionary trust, you are not presently entitled to any distribution from the trust until the trustee has exercised their discretion in your favour in any given income year. Until the discretion has been exercised, you have, at best, a mere expectancy of receiving income from the trust. A mere expectation is not considered to be sufficient to establish a nexus between assessable income and expenditure incurred.

IT 2385 followed the Administrative Appeals Tribunal decision in QT 85/1311 where the taxpayer was a beneficiary of a discretionary trust and was not under any legal disability. The taxpayer was a director of the corporate trustee of the trust and his only source of income was a distribution from the trust. The taxpayer claimed as a deduction against the trust distribution, under subsection 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936) (equivalent to section 8-1 of the ITAA 1997), expenses including bank interest.

The Tribunal held that the taxpayer was not entitled to any deduction as the expenditure was not incurred in gaining or producing the taxpayer's assessable income. The taxpayer had not shown that there was a sufficient nexus between the expenditure incurred and the receipt of the income. At its highest the taxpayer had a mere expectancy of receiving income from the trust as the taxpayer was not presently entitled to the income of the trust when the expenditure was incurred.

In your case, the future proceeds on the sale of the townhouses constitute the income anticipated to be received from the trust. The interest expense on the private loan has been incurred prior to the trustee exercising their discretion in favour of the beneficiaries. Accordingly, until you are presently entitled to any trust income, you are unable to claim a deduction for interest expenses under section 8-1 of the ITAA 1997.

Question 2

Detailed Reasoning

Taxation Ruling TR 95/25 considers the deductibility of interest. The basic test for deductibility of interest on borrowed money is the use to which the funds are put. As a general rule a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of a person other than the one who incurs it; FC of T v Munro (1926) 38 CLR 153.

In the trust's case, the loan was taken out by the beneficiaries who then invested in the money into the trust. Although the trust is utilising these funds, the trust itself did not acquire the loan and therefore did not incur the interest accrued on such money.

Accordingly, the trust is not entitled to claim a deduction for interest expense on the beneficiaries' personal loan, under section 8-1 of the ITAAA 1997.